Hi-Stat Vox No. 10(November 10, 2008)

Game Theoretic Approach to International Political Economy

Taiji Furusawa

Professor, Graduate School of Economics, Hitotsubashi University

As in many other fields of economics, game theory has been contributing greatly to the development of international trade theory. A game theoretic approach is essential to the analysis of cross-boarder competition among firms. Negotiations and cooperation among governments on trade policies and environmental issues are also compatible with a game theoretic environment in which a relatively small number of countries act strategically as players. Game theory is also applied to political economic issues between the government and corporate sector, such as industrial lobbying activities. This article briefly introduces international political economic issues which international trade theory has been solving (or trying to solve) using game theory, with a focus primarily on strategic interactions over trade issues that I have studied.

A game in which governments seek to determine their own trade policies as players has the structure of the prisoner’s dilemma. The so-called theory of optimum tariffs says that large countries benefit through an improvement in their terms of trade by raising tariffs and other trade barriers to some extent. Even for small counties whose economic activities do not have an impact on world prices, the optimum trade barrier for governments is not necessarily zero in most cases, given political objectives such as the protection of industries that compete with imported goods. However, if all countries set trade barriers to maximize their own benefits alone, almost every country (except for the superpowers) would consequently have to accept lower levels of welfare than would be the case with free trade. In spite of the fact that cooperative trade policies are Pareto-optimal, each country tends to end up adopting non-cooperative trade policies, pursuing its own interests.

Consequently, the presence of the World Trade Organization (WTO) becomes important. To achieve the Pareto-optimal free trade or to come as close to this as possible, the WTO offers a forum for trade negotiations to encourage member countries to adopt more cooperative trade policies. In fact, through the eight postwar rounds of the General Agreement on Tariffs and Trade (GATT) negotiations, member countries have succeeded in substantially reducing tariff barriers, particularly for manufactures. It has also been pointed out that the WTO has been playing a more active role than simply offering a bargaining table. For example, Bagwell and Staiger (1999, 2005) showed theoretically that the principle of nondiscrimination and reciprocity, the two major principles of the GATT and the WTO, make a significant contribution to reciprocal trade liberalization. It is also highly likely that individual nations will have a stronger incentive to comply with agreements if the WTO is actively involved in multilateral negotiations and supports them (Furusawa, 2009).

Unlike domestic law, it is inappropriate for international agreements (international laws) to set out strong punitive clauses for violations of agreements (laws). A country that has violated an agreement cannot be put in prison. It is therefore necessary to think about effective penal provisions that can be an alternative to prison, while promoting voluntary compliance. Even if tariff barriers are successfully reduced through multinational negotiations, it is meaningless unless the reductions are lasting. Dixit (1987) showed by applying the folk theorem of game theory that stable trade liberalization will be achieved under a mechanism in which, if a violation occurs, a trade war results. If the penal provision of a trade war is included, a blueprint for an effective international agreement can be drawn.

To impose effective and efficient sanctions for violations of an agreement, it is necessary to ensure that trade agreements are transparent. If trade policies are opaque, it will be impossible to make an accurate judgment as to whether an agreement has been violated or not in the first place. In fact, if the transparency of trade policies is completely ensured, it will be possible to maintain a stable cooperative system simply by including in the agreement a provision such as “if a violation of an agreement is observed, the agreement will be immediately annulled.” This is why this kind of cooperation mechanism is called a self-enforcing mechanism. If this mechanism works well, the WTO will not need to play any role other than offering a forum for trade negotiations. In reality, however, trade policies are opaque, as there are various kinds of uncertainties and asymmetry of information. The WTO contributes to realizing sustainable trade liberalization in a world of uncertainty, for instance by helping to increase the transparency of trade policies through its dispute settlement mechanism and making it possible to take punitive measures only when suspicion of a breach of an agreement is sufficiently keen (Furusawa, 2003).

It is only when a cooperation mechanism has been determined that the sustainability of liberalized trade and measures to that end as well as the role of the WTO can be sought. The development of the field of a repeated game that has dramatically deepened our understanding of the cooperation mechanism has been making a significant contribution to the design of the international cooperation system for trade policies.

To this point, the article has looked at an analysis of the international cooperation regime based on the application of the repeated game approach. We now move on to a discussion about the application of a new game theory to regional free trade agreements from a slightly different perspective. As symbolized by the stalling of the Doha Round, multinational trade negotiations have had increasing difficulty finding success in recent years. Instead, there has been a trend in which a free trade agreement (FTA) has been concluded between two or several countries. How far will these agreements, which intrinsically discriminate against non-member countries, proceed? Will FTA continue to move ahead to the point that it becomes possible to say that every country has free trade?

One promising analytical method to answer this question is an approach from the network-formation game. Goyal and Joshi (2006) and Furusawa and Konishi (2007) analyzed the global network of FTA by applying the network-formation game developed by Jackson and Wolinsky (1996). One important characteristic of this analysis is that the stability of the worldwide FTA network can be discussed in the analytical framework of an arbitrary number of countries. Theoretical studies about FTA conducted within the framework of a three-country model, which have been conducted in most cases in the past, did not allow us to discuss some important issues such as the feasibility of the FTA network with three economic components of the Americas, Europe, and Asia. I believe that we have now been able to conduct much deeper theoretical studies of practical and interesting themes involving FTA using the network-formation game, which is suitable for the multi-country framework of FTA analysis.

The study of the FTA network has just begun. In a multi-country model with different population and industry sizes, Furusawa and Konishi (2007) discussed incentives for each country to conclude an FTA agreement and derived the conditions for a FTA network to be stable. Due to the complexity of the model, however, our major analysis was to discuss the stability of a complete global free trade network that encompasses all bilateral relations in a static framework. It is hoped that a dynamic analysis of the FTA network will be conducted in the future. It is likely to become possible for us to predict to some degree how and to what extent the FTA network will develop globally, in simulation analyses that have traditionally been avoided more or less for this topic.

International trade theory has exhibited considerable dynamism in recent years. This is a movement to incorporate firm heterogeneity, which has its roots in the studies of Bernard, et al. (2003) and Melitz (2003), into a general equilibrium analysis. Until their studies were published, a seemingly obvious phenomenon—many firms with different productivities and different aspects coexist within a single industry, engaging in different exporting activities—had not been discussed in the framework of a general equilibrium analysis. Now, a number of trade models that explicitly incorporate the existence of heterogeneous firms have been proposed, and studies are being developed to consider the effect of trade policies at a firm level. Of course, each firm competes with domestic and foreign rivals within its own country and internationally. There are also many cases in which firms cooperate with other firms in research and development, production activities and distribution, among other areas. Issues between management and labor such as negotiations with labor unions also exist. These issues are influenced by the heterogeneity of firms and, at the same time, are the factors generating that heterogeneity. It goes without saying that game theory is useful for analyzing these interactions between economic agents that are waged at the micro level.

The global economy consists of a large number of game-like structures that overlap at multiple levels. In other words, the global economy is composed of multiple game-like structures such as those between employees in a firm, the relationship between labor and management, competition and cooperation among firms, relations between firms or industries and the government, and international relations among governments. Game theory is likely to continue to find increasing application to the field of the international trade theory. It will also be used for models at multiple levels by accurately reflecting the layered structure of the economy.